Why are Momentum Profits Procyclical?

We offer a risk-based explanation for the procyclical nature of momentum profits. We show that a model that contains the market return and innovations in market variance explains a large proportion of momentum profits in good times. The price of risk for market variance in good times is negative. Recent winners have high expected returns since winners load negatively on aggregate market variance. Recent losers have low expected returns since losers load positively on aggregate market variance. This effect is especially pronounced in good times. The spread in market variance loadings in good times between winners and losers explains between 65% and 95% of the difference in their average returns. We offer a growth options explanation behind our results. Using the growth rate of capital investment as a proxy for the exercise of growth options, we show that the investment growth rates of winners increase before portfolio formation and decreases thereafter. The opposite pattern is observed for losers. Therefore, the evidence suggests that winners tend to exercise their growth options before portfolio formation, and they gradually accumulate them after. Losers do the reverse. Therefore, at portfolio formation, losers tend to have more growth options which increase in value with variance. Thus, losers have low expected returns since they represent hedges against increases in market variance.